It is also vitally important to understand that the amount of upside potential that can be offered by an FIA will vary over time as interest rates and call option prices change. With an annual reset design, the insurance company must repeat this process each year and will face different interest rates and call option pricing as these variables change values over time. More upside potential is possible with higher interest rates and cheaper call options, and vice versa.
This is the reason why insurance companies maintain the freedom to change the contract parameters (such as the fixed rate, participation rate, cap rate, or spread) at the beginning of each new term, subject to a minimum or maximum value allowed for each parameter within the contract. For those minimum or maximum limits, the boundaries of what the insurance can use may be extreme, such as the potential to cap interest at 0.25 percent for a term. This flexibility is necessary because the insurance company does not know beforehand what the ongoing options pricing and interest rates will be when it is time to renew the process at the start of each new term.
Insurance companies have discretion to change the FIA parameters in a way that would make them less competitive after the fact. A company could offer good introductory parameters on the FIA, but it could change the parameters in an adverse way for subsequent terms in a manner not justified by fair pricing. A company could reduce the options budget so that it keeps more. In comparing FIAs between different companies, it is also important to investigate a company’s history regarding changes to its FIA parameters. Does the company have a history of adjusting parameters in an adverse direction, especially during years when surrender charges still applied? If so, this could serve as a red flag about purchasing that company’s product.
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Some companies will be more effective than others in managing potentially adverse changes from the consumer’s perspective. For FIAs with surrender charges, insurance companies will often invest in longer-term bonds matching the length of time that surrender charges remain and will seek as best they can to avoid any adverse change in parameter values before the end of the surrender charge period.
Companies must maintain the right to change parameter values at the start of new terms in order to reflect the realities of changing capital markets, but high-quality companies will make the effort to place the customer’s interests first and to not use this nontransparent process to extract additional value from the consumer.
This discussion should also help to make clear why it becomes more difficult in practice to simulate the performance of FIAs. Modeling their performance is more complex than modeling returns for traditional asset classes like stock and bonds. The simplest approach to modeling FIAs is to assume that their current parameters (such as floors, caps, participation rates, and/or spreads) would have applied equally in the past. However, this is not satisfactory because changing market conditions over time would have led those parameters to also be different. As well, many FIAs have just been created recently, and the oldest FIA dates back only to 1995, so that relying on their historical returns or historical parameter values is not an option.
To obtain a better sense about what their past parameters could have been, a more complete model to price FIAs must account for the risk-free interest rate, the broader yield curve and credit spread, internal insurance company costs and the amount available for the options budget, the implied volatility of the underlying index linked to the FIA, and the dividend yield for the underlying index.
Many of these variables are outside the scope of what Monte Carlo simulations would generally include. Some of these variables are not readily observable. In particular, insurance company expenses and assumptions about the performance of their investments, as well as the implied volatility of the stock market are variables that will require assumptions. Simulations of FIA performance will only be as reliable as the underlying assumptions used.
To summarize, the factors affecting the degree of upside participation that can be offered by an FIA include the level of interest rates, the factors affecting options pricing, the strength of the downside guarantee protection, company expenses, company pricing assumptions and whether the company is pricing the FIA to be competitive in the marketplace.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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